HOUSING FINANCE AND EQUITY CAPITAL MARKETS

The bulk of the literature on analysis of the potential of the US housing finance markets to serve underserved population and areas has been based almost exclusively on mortgage lending business models. Some authors even examined how far the industry could go in expanding homeownership opportunities if income or credit constraints were totally relaxed in mortgage loan underwriting. There is no doubt that the 1990s saw record homeownership rates and major strides in closing the gap between majority and minority homeownership rates. Despite the various demographic challenges that the industry confronted, lenders made important inroads in increasing low-income homeownership. New marketing techniques, aggressive outreach and availability of loans with increasingly higher loan to value ratios contributed to these gains. Armed with more sophisticated underwriting standards, new product types, and a mandate for experimentation, the housing finance industry attacked down payment and credit standards that constrained borrowing for many families on the margin of homeownership. One concern that has arisen is that the excessive focus on the mortgage side of homeownership financing leaves new homeowners overleveraged. Increased mortgage debt imposes a risk of default and of affordability. It causes homeowners to reallocate cash budgets to debt service, thereby reducing cash available for other expenditures. Another problem is that mortgage debt receives favorable tax treatment, including deductibility in computing taxable income. Low- and moderate-income buyers have by definition low- and moderate income. Therefore they benefit relatively less from the tax advantages of debt. The cost of capital for any household is a weighted average of the cost of equity and the cost of debt. For a given cost of equity capital, a household with a low or zero marginal tax rate has a higher after-tax cost of debt capital. Therefore the cost of capital is higher for low- and moderate-income households, and that is accentuated by emphasizing leverage, or debt finance. A third problem is the impact of leveraged finance on the physical stock of housing capital. If leveraged homeowners tend to default, and that leads to foreclosures, there is a contagion of low-quality housing in a given neighborhood. Leveraged housing finance creates a negative externality. The long-time homeowner with relatively low leverage sees a decline in housing values caused by the entry of risky and leveraged neighbors. Some of these problems can be resolved with shift of focus to the equity side of the cost of capital for homeownership. Consequently, this paper discusses methods for financing housing for low-income households to emphasize equity instead of debt. First, the paper examines the various problems that low-income households have with the current debt-orientated homeownership financing system. With a zero marginal tax rate these households do not benefit from the deductions for mortgage interest or tax-free imputed rent. With substandard collateral and characteristics, these borrowers typically do not qualify for conventional financing. The result is that conventional financing accounts for less than one-third of the housing finance taken up by low-income households. The other two-thirds consists of loans with explicit government backing and sub-prime private lenders charging higher rates and under constrained conditions. Given their lack of wealth, low-income borrowers fund equity informally through mutual pooling arrangements or unrecorded debt. Of course, many more simply do not become owners. Second, the paper models a three-tiered instrument involving equity, mezzanine finance and debt. // Equity: Pooling. Equity markets are enhanced by formalizing pooling contracts, such as rotating savings and credit accounts widely used by low-income borrowers, targeting at least 5% down payments. // Mezzanine: Credit enhancement. Mezzanine finance comes through pools providing 15% to 20% of the house price placed as debt or equity. The credit enhancement allows debt finance and limits the loan-to-value ratio to 80%. // Debt: Conventional plus. The debt is a hybrid between the conventional market and subprime, targeting borrowers who cannot qualify conventionally. Potential homeowners save for equity through savings accounts that allow rotating lump-sum draws. Contingent on the size of their down payment, a mezzanine fund provides additional funding at closing. The return on the fund is from a premium over the conventional prime mortgage rate and either an equity position or a look-back second mortgage with no payment. The homeowner receives an interest in the mezzanine fund. The paper examines the implications of securitizing the mezzanine fund, leading to a tradable security backed by home equity shares, the last large illiquid asset in wealth. // The paper concludes with a discussion of key market impacts of a housing financing regime that shifts its orientation more to increasing participation of the equity capital markets. Low-income borrowers move from loans with high non-deductible interest rates in the subprime market and from government loans with moral hazard and default risk to loans with lower rates, higher equity and a diversified portfolio. The program combines the community ties of informal savings accounts with formal safeguards from a tradable mezzanine equity fund. This monitoring and lower leverage reduces the default risk while retaining the low prepayment risk of these borrowers. he arrangement helps conventional conduits meet regulatory mandates to lend to low-income borrowers and have new product lines in the mezzanine and equity funds.